The Art of Selling

by

Tim du Toit
www.EuroShareLab.com

© EuroShareLab
 Table of Contents
Introduction..........................................................................................................3
Why is it important to limit losses?...................................................................5
Behavioral aspect of selling..............................................................................7
Selling to realise a gain....................................................................................10
Movement of the share in the ranking........................................................10
When your premise is fulfilled ....................................................................10
After a substantial rise in price....................................................................10
When it doubles.............................................................................................11
Selling to limit a loss.........................................................................................12
Your reason for making the investment.....................................................12
Leave emotions out of it...............................................................................12
When your nerves can't take it any more..................................................13
Percentage drop in price..............................................................................13
My approach......................................................................................................14
How it works:.................................................................................................15
Loss of more than 16%................................................................................15
Loss of more than 25%................................................................................15
Gain of more than 50%................................................................................15
An Example....................................................................................................16
Summary and conclusion................................................................................17

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Introduction
Have you ever wondered how you managed to acquire and keep holding
a loss-making share in your portfolio?

That is exactly what happened to me and I vowed to do something about

it!

The only problem was....

I found countless books written on how to buy shares, based on many

different investment strategies.

They go into great detail about what to look for, when is the best time to
buy a share, how to structure a portfolio, how to ensure diversification,
and they also consider asset allocation.

But when it comes to selling a short paragraph at the end is all the reader
gets; almost an afterthought.

Over many months of research on the internet, talking to successful fund

managers, and reading what I could find, I have put together the following
report.

What I have realised is that selling, which is as much an art as it is a

science. More importantly you have to find a selling strategy that fits
comfortably with your nature.

There are no ironclad rules; you have to deal with selling yourself as only
you will know how much of a loss you can tolerate.

If you have trouble sleeping at night, knowing you have lost 25% on an
investment, set your stop-loss point at 20%, or slightly lower at 18%. This
will ensure that your loss, including commission and a possible lower sale
price, will not be more than 20%.

What I cannot emphasise enough though is that you should have a selling
strategy. You should have it written down, and you must review it
regularly.

Then you have to force yourself to follow it.

If you do not do this you will make all sorts of excuses to justify why you
are still holding a loss-making investment.

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I have my selling strategy as a “To Do” item, and it comes up every
Monday morning on my organiser. I sometimes just quickly review it and
click it away. At other times I add a comment, of change it.

It’s a living document that reminds me constantly about my approach to

the selling of investments in my portfolio.

My aim with this report is to give you an idea as to how you can approach
selling. There is no correct way; just ensure you devise one that you feel
comfortable adopting and implementing.

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Why is it important to limit losses?
Limiting losses is very important as the increase needed to recover the
loss grows exponentially as the loss gets larger.

A 10% loss requires an 11.1% recovery in the share price to break even
again. Similarly, a 50% loss requires a 100% increase to recover as you
now will have only half of your original capital.

The following table and graph show the relationship between a loss and
the recovery visually.

Increase to
Loss recover loss Loss Increase to
recover loss
5% 5.3%
10% 11.1% 2000%
15% 17.6%
20% 25.0% 1800%
25% 33.3%
1600%
30% 42.9%
35% 53.8% 1400%
40% 66.7%
45% 81.8% 1200%
50% 100.0%
1000%
55% 122.2%
60% 150.0% 800%
65% 185.7%
70% 233.3% 600%
75% 300.0%
400%
80% 400.0%
85% 566.7% 200%
90% 900.0%
95% 1900.0% 0%

Whatever approach you take to selling, this is the most important principle
to bear in mind, irrespective as to how positive you are on the recovery
probability of the losing investment in your portfolio.

Another example.
Assume you are targeting a 15% annual gain on your portfolio. You have
just invested 1,000 in a share it has dropped, and you sell it at a 25% loss
(i.e. you have lost 250).

At the same time you have invested in two other shares at 1,000 each,
and have made an average gain of 35% (700) on both of them.

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On your total investment of 3,000, you have now made 450 (700 minus
250), which equals a 15% return.

What would have happened if you had held onto your losing stock a bit
longer before getting out? For example, if your 1,000 investment drops
50%, you have lost 500. That means you would have to make almost a
50% average return on your two other 1,000 investments to have a 15%
return on your total portfolio.

Making a 35% annual gain on stocks can be achieved, but making 50%
consistently is, however, a different matter.

But it could be even worse. If you had let your first share drop 75% before
selling, you would have had to make 60% on your other two shares just to
make a 15% return on your overall investments. While 60% is possible,
it's extremely hard to do.

So by letting your losses increase, you have put yourself in a position

where you have to make exceptional stock selections just to make
average returns.

Loss of 25% Share 1 % Share 2 % Share 3 % Total %

Investment 1,000 1,000 1,000 3,000
Gain / (Loss) (250) -25 350 35 350 35 450 15

Loss of 50%
Investment 1,000 1,000 1,000 3,000
Gain / (Loss) (500) -50 475 +48 475 +48 450 15

There is another reason why limiting losses, especially large losses, is

important. Losses can cause you to lose confidence in your ability to
make investment decisions. This means that not only do you have to
consider the current loss, but also the future profits not made, because of
your lost confidence.

If large losses are so devastating to our returns, why do we allow

ourselves to get into such a loss situation? The reason is that selling an
investment at a loss involves not just an order to your broker, it also
involves psychological and behavioural elements.

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Behavioral aspect of selling
Fear and regret play a large role in investors failing to sell a stock that has
declined.

Sometimes when a stock falls, it’s a great opportunity to increase the

investment at an even more attractive price.

But in cases where investors have made an obvious mistake, and

logically should sell immediately, behavioural research shows that they
will often hang on, thus suffering even greater losses.

Why is this?

By selling, they have permanently locked in the loss, and then have to
confront the pain and regret of having made a bad investment, including
the potential embarrassment of disclosing the loss to family or other
investors.

The argument that losers in your portfolio will outperform in the future
doesn’t generally hold up to scrutiny. After analysing the trading records
of 10,000 discount-brokerage accounts, Terrance Odean, concluded that
“Investors who sell winners and hold losers because they expect the
losers to outperform the winners in the future are, on average, mistaken”.
Odean found that selling winners that had increased in price beat a
market index over the following two years after sale by 6.5%.
Interestingly, the losing investments that were sold also beat the market
index over the two-year period, but by only 2.9%.

Take the idea behind what is called as the “sunk-cost fallacy”. We are
obsessed with what it costs us to buy an investment. The cost of our
investment is not just a financial commitment, it’s also an emotional
decision. We like to think we were right. If the price of a stock moves up
after we buy it, we take it as evidence of our intelligence and investing
skills.

Here is an experiment I recommend to you.

1. Take a look at your portfolio without considering what it cost you to
buy the investments.
2. All you have is the name of each stock, the number of shares you
own, the current stock price of each investment, and its current
market value.
3. Total up the last column to estimate the liquidation value of your
portfolio. Note: you have no idea about the cost of the individual
investment, or of the entire portfolio.

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 4. As objectively as you possibly can, ask yourself this question: “If I
did not own all these stocks, but instead had the cash equal to their
current market value, would I buy them today?” Ask this question
about every stock in your portfolio. Sometimes the answer will be
an overwhelming “yes”. But when the answer is overwhelming “no”,
you have to ask yourself why the stock is still in your portfolio.

The reason why this experiment is useful is because it forces you to

forget about the cost. It also forces you to start from a clean slate. When
you start from a clean slate, your past decisions will often appear to be
irrational; especially when they are compared with other, better
alternatives. When you leave the baggage of past decisions behind, and
start from a clean slate, you tend to become more rational.

Somehow, in our minds, we think that our ownership of something

increases its value. This is incorrect. For example, just after placing bets,
punters at the racetrack become much more confident about their horse’s
chance of winning the race. Similarly, lottery ticket buyers tend to buy
more frequently if they are allowed to choose their own numbers.
Investors in shares are no different. Remember a share does not know
that you own it!

So what can we do to avoid costly and annoying errors?

• Approach investment decisions from as neutral a position as
possible.
• Ignore all sunk costs by using the method described above.
• Accept it as inevitable that you will make mistakes in your buying
decisions.
 You will face tremendous pressures that will
tempt you to rationalise your mistakes and not
correct them.
 You will tend to protect the status quo by
inventing new reasons to hold on to a bad
investment.
 This will be especially true when your original
buying decision is known to many other people
who are important to you, as it will hurt you to
acknowledge this to them, and to yourself.
 It will be difficult for you to correct the mistake
because you will attach more importance to
saving face by appearing to be consistent with
your past commitments.
• Don’t overvalue your current positions. Pretend that you don’t own
them, and ask, “If I didn’t own this stock today, would I buy it?” If
the answer is no, you should think hard about selling.

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 • Don’t compound past mistakes for fear of embarrassment. In the
end, the best advice is to learn from mistakes and move on.

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Selling to realise a gain
Selling for a gain in contrast to selling to limit losses is a pleasurable
experience. In this chapter I will explain what strategies you can use to
maximise your gains.

Movement of the share in the ranking

If you buy stocks based on a ranking or mechanical strategy, such as a
low price to earnings ratio, low price to book ratio, or high dividend yield,
the movement of the stock from cheap to expensive through the ranking
can be used to determine the selling point.

If the strategy is based on buying the cheapest 10% of shares in terms of

price to book ratio, you can set your sell point as the shares reaches the
mid point in the ranking. This will save you from being overly enamoured
with a stock and free up funds to invest in the target part of the strategy.

Also, when a company in your portfolio starts to reach market average or

peer-group multiples, it may be time to exit the investment. For
companies to trade at better than market or peer group average
valuations they have to be exceptionally better businesses. If this is not
the case it may be time to exit the position.

When your premise is fulfilled

This is what it is all about - selecting a share because of a reasoned, well-
thought investment premise, and things work out exactly like you
expected, or better. When this happens you have every right to feel
confident and take your well earned profits.

Should the premise, however, not work out, it may be best to sell the
share rather than thinking of new reasons to hold onto the investment,
whether you have suffered a loss or not.

After a substantial rise in price

Another reason for selling is when you think the stock has become more
valuable than it should really be.

This is often hard to determine, as many companies continue to grow and

perform after their share prices have increased substantially.

Sadly, for many of us, the realisation that a stock price has increased too
much comes long after the price has already peaked and started to fall.

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Another factor to consider is the quality of the company. If it’s a high
quality business, earning high returns on capital, or the industry is
growing strongly, you may want to give these companies more of a
chance to run.

An example
I bought the German steel and pipe manufacturing company, Saltzgitter,
in August 2003. It was trading at 50% of book value with a debt to equity
ratio of 15%. I sold half my position in December 2004 with a 115% gain
when I became uncomfortable with the booming steel price and this basic
commodity company's stock price was reaching new highs. After I sold
the share the price appreciated another 900% before falling back sharply.
I should have let it run even though I made a really good return.

It is important to note that taking the first run up in the stock price from an
undervalued share is the lowest risk profit. Holding on for the last cent
becomes more and more risky.

However, if the value keeps building in the business, so that the valuation
metrics stay the same in spite of the share price increasing, you should
be patient before selling.

Furthermore, slightly over-priced stocks in the hands of skilled

management can be used as a currency for making acquisitions and
building the business. So you should not be entirely averse to holding a
share should this be the case.

When it doubles
An old adage in the market is that you should sell half your holdings when
a stock doubles. This is a purely emotional reason to sell a stock. But for
many, it works.

It allows you to feel like you have received all of your money back and
that the money you now have in the share is pure profit or "house
money".

The concept of "house money" is purely emotional as all the money,

including the gain, is always all yours.

But if selling half when a share doubles makes it easier for you to hold the
investment, then this is a sound strategy.

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Selling to limit a loss
Your reason for making the investment
Once you have done your homework on a company, write down your
concise reason for buying.

Should the share decline more than 15%, re-evaluate the company to see
if the original reason for buying is still in place. If your original reason for
buying has not changed, either buy more or remain invested.

You may ask a friend or other trusted investor to take a fresh look at the
share to see if they come to the same conclusion. This is also a great way
to objectively test your reasons for staying invested.

Another rule you may want to consider, after confirming your analysis is
that the position is never a hold. It’s always a buy or sell - the position has
either become more attractive or it has not.

Should you use this selling strategy, you may want to implement a strict
rule that if you were wrong about the reason for investing, you should exit
the position with no questions asked. Never invent new reasons to hold a
position when the original reasons are no longer applicable.

Holding onto a position simply to recover your initial capital is usually a

recipe for even greater losses.

Selling when you are negatively surprised by an investment is another

factor to consider. If you are truly surprised, it usually means
management is also surprised, and there may be something
fundamentally wrong with the business.

Leave emotions out of it

Should it happen that management really makes you angry, you may
want to put the investment away for a while and not do anything. Try not
to take action just because of your emotions.

It has happened in the past that the management decisions made me

angry, by voting through a takeover defense, for example. My natural
reaction would be to just sell the stock and move on, but if I had reacted
in that emotional way, it would have cost me a lot of money.

If you take action because of an emotional reaction, it is likely that a lot of

other investors are thinking exactly the same. This means that everyone

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is abandoning the investment at exactly the same time. I have found it
better to wait a while, even if I am still angry.

When your nerves can't take it any more

Have you ever bought a stock that has taken you for an emotional roller-
coaster ride? Instead of increasing in value the price dips and bounces
every day.
If holding the stock makes you so uncomfortable that you can't sleep and
you only worry about how much money you have lost or made in a single
day, you are being distracted.

When that's the case, consider holding less volatile stocks or decrease
the size of your position. Know yourself. Don't hold stocks that you can't
hold comfortably.

Percentage drop in price

This strategy is the simplest of all, but also much more difficult to
implement than it looks.

Sell after a fixed percentage decline in price. This level can be set by
looking at the recovery table mentioned above, or can arbitrarily be set
according your pain threshold.

From experience I can say that sticking to such a strategy is much more
challenging than it may seem at first. The difficulty in selling at a certain
percentage increases exponentially, depending on the amount of
research you have done before investing in the share. The reason can be
attributed to the behavioral problems associated with selling.

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My approach
Below is a diagram of my approach to selling. It’s a combination of the
many considerations mentioned above.

The loss and gain levels are arbitrary, but they are ones I feel comfortable
with. You can use it as a basis to build your own selling strategy.

Even though I developed it and feel comfortable with the arguments and
values, I still find it difficult to stick to.

The toughest decision is to sell according to the model when I think the
share is down due to a negative day for the stock market overall, or
negative industry news.

The most frustrating is when I did not sell at a 25% loss and the loss then
increased to 33% or more.

Share Price Movement

Loss > 16% < 25% Yes

Have added to position? Yes Independent valuation Gain > 50%
No Yes

Analysis at current price: Bad Business?

- Has business or prod deteriorated? Cigar Butt
- Was I wrong about the business
- Is management integrity gone? Yes
- Negative surprise?
- Will I not buy the share at this price? Sell
No
No
Yes
Just irrational price move or PE or multiple expansion
temporary bad news
Yes No
Sell
Sell first (Tax loss)
Them buy more Sell Hold

Loss > 25% Sell

A bigger diagram can be found on the last page

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How it works:

Loss of more than 16%

If the share price declines more than 16%, I first ask if I have already
added to the position. If not, I redo the analysis. If the business has not
deteriorated in one of the five factors mentioned, then I buy more after
selling the position to make use of any tax losses. The position is never a
hold - either I buy more as the investment has become more compelling,
or if it has not, I sell.

Should I have increased my position, the loss on the new total position
would have decreased as my average purchase price has declined.

Should my loss again exceed 16% after I have bought more shares, I ask
a friend or fellow investor to redo the analysis. I use this objective review
to determine if I have missed anything in my analysis. Should the
independent evaluation come to the conclusion that it is a good
investment, I may buy more or I may just hold, depending on the size of
the position in my portfolio.

Loss of more than 25%

In order for a loss to exceed 25%, I would have had to go though my own,
and an independent, review of the position when the loss got to 16%.

At this point I cut my losses. I may be wrong in selling but I can always
buy the share again.

Selling at this point has enabled me to get out of a position where it has
later shown that something was happening in the market or with the
company, that I did not understand.

Gain of more than 50%

Should my gain on the investment exceed 50%, I also review the position.

If the investment was a “Cigar butt”, a description Benjamin Graham gave

to cheap, bad quality businesses, I exit the position as the lowest risk
gains have been made.

If the investment is a high quality business, I determine if the gain has

been purely price-based with no change in the earnings of the business.
Should the former be the case, I may sell right away, or may still hold if
the valuation is lower than the market or peer group based on price to
earnings ratio, for example.

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Should the earnings of the investment have increased along with the
price, I will hold the share.

As you can see, my approach to selling is mainly sticking to the “rules”,

but it allows some decision freedom. What I really try to stick to is the
hard rule of selling out at a 25% loss.

An Example
To clearly explain my approach, I will work through an actual example:

• About a month after I bought Dell Inc., the computer company, the
share price fell 17%.
• The following day I looked at my financial analysis and made sure
there were no updated financial or recent news I was not aware of.
I found nothing, apart from uncertainty around worldwide computer
shipments in the coming year.
• I added to my position.
• This lowered my loss to 11%, as my average purchase price was
lowered by the additional shares.
• About six weeks later my loss again exceeded 16%.
• This time I asked a friend to work through my financial analysis to
see if he found the company an attractive investment. Apart from a
few points he also thought it an attractive investment.
• I decided to hold the position and not buy additional shares.
• Three weeks later my loss on Dell exceeded 25% and I sold the
position. From what I could gather the share price decline was
caused by weak sales results by Lenovo Group, one of Dell's
competitors.
• Having sold the share I was in the position to objectively and
unemotionally evaluate what I wanted to do from there going
forward - repurchase the share after waiting for the situation to
stabilise, or look for alternative investments.

What happen?
Dell's share price recovered slightly after I sold, but subsequently went on
to lose a further 20%.

The sale thus had a good outcome, but even if the share had recovered I
would have been pleased as it limited my losses and gave me complete
emotional freedom to evaluate my options.

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Summary and conclusion
My goal with this report is to show that it is important to think of your
selling strategy in advance of making your investments, and to make it
clear that selling is a lot more difficult than it looks.

The most important points in this report are:

1. Have your selling strategy written down.
2. Look at it often.
3. Make changes as you gain additional insight.
4. Stick to your selling strategy – no exceptions!

I wish you all the best with your investment endeavours.

Please send your comments and experiences by clicking on the following

link:

www.eurosharelab.com/contact-us

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 Share Price Movement

Back To TOC
Loss > 16% < 25% Have added to position? Independent valuation Gain > 50%
Yes Yes
No Yes

Analysis at current price: Bad Business?

- Has business or prod deteriorated? Cigar Butt
- Was I wrong about the business
- Is management integrity gone? Yes

- Negative surprise?
- Will I not buy the share at this price? Sell
No
No

Yes
Just irrational price move or PE or multiple expansion

http://www.EuroShareLab.com/
temporary bad news

Yes No
Sell
Sell first (Tax loss)
Them buy more Sell Hold

Loss > 25% Sell

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